Author(s):

Abstract:

Armen
Alchian was one of the great economists of the twentieth century, and his 1950
paper, Uncertainty, Evolution, and
Economic Theory, one of the most important contributions to the economic
literature. Anticipating modern behavioral economics, Alchian explains that
firms most decidedly do not – cannot – actually
operate as rational profit maximizers. Nevertheless, economists can make useful
predictions even in a world of uncertainty and incomplete information because
market environments “adopt” those firms that best fit their environments,
permitting them to be modeled as if
they behave rationally. This insight has important and under-appreciated
implications for the debate today over the usefulness of behavioral economics.

Alchian’s
explanation of the role of market forces in shaping outcomes poses a serious
challenge to behavioralists’ claims. While Alchian’s (and our) conclusions are
born out of the same realization that uncertainty pervades economic decision
making that preoccupies the behavioralists, his work suggests a very different
conclusion: The evolutionary pressures identified by Alchian may have led to
seemingly inefficient firms and other institutions that, in actuality, constrain the effects of bias by market
participants. In other words, the very “defects” of profitable firms — from conservatism
to excessive bureaucracy to agency costs — may actually support their relative
efficiency and effectiveness, even if they appear problematic, costly or
inefficient. In fact, their very persistence argues strongly for that
conclusion.

In Part I, we offer a
short summary of Uncertainty, Evolution,
and Economic Theory. In Part II, we explain the implications of Alchian’s
paper for behavioral economics. Part III looks at some findings from
experimental economics, and the banking industry in particular, to demonstrate
how biases are constrained by firms and other institutions – in ways often
misunderstood by behavioral economists. In Part IV, we consider what Alchian’s
model means for government regulation (with special emphasis on antitrust and
consumer protection regulation).